Accounting Treatment of Closing Stock
What Is Meant by Closing Stock?
For trading businesses, closing stock consists of different types of finished goods. For manufacturing businesses, closing stock consists of raw materials, work-in-progress, and finished goods.
The unsold closing stock of the current year is the opening stock of the next year. Given that the current year’s unsold closing stock will be sold in the next year, its cost is not an expense of the current year; instead, it is an expense of the next year (when it will be sold).
For this reason, any closing stock is entered on the credit side of the trading account.
Application of Convention of Conservatism
The convention of conservatism states that whenever closing stock and other current assets (e.g., short-term investments in marketable securities) are recorded, they should be recorded at cost price or net realizable value (market value), whichever is less.
At the end of 2019, suppose that closing stock appears in the books at a cost price of $25,000, but the market price at that time is $30,000. The excess amount, $5,000, is profit based on the expectation that it will be earned when the stock is sold in the next year.
Therefore, anticipated profit will not be considered and closing stock will be recorded at the cost price of $25,000, which is lower than the market price or net realizable value. As the convention says, don’t expect to make a profit.
Suppose that closing stock appears in the books at a cost price of $25,000 at the end of 2019, but its market price at that time is $22,000. When the stock is actually sold in the next year, there will be a loss of $3,000 (25,000 — 22,000).
Although this loss will occur in the next year when the stock will be sold, it is a “possible loss.” Therefore, it should be recorded in the current year and the closing stock will be recorded at the market price of $22,000 (which is lower than the cost price).
This is consistent with what the convention of conservatism requires in terms of providing for all possible losses rather than assuming profits will be made.
Reason for Recording Closing Stock on Credit Side of Trading Account: Application of the Matching Concept
To calculate gross profit or gross loss, direct expenses are matched with direct revenues. All direct expenses are recorded on the debit side of the trading account, while direct revenues are recorded on the credit side.
Closing stock is also recorded on the credit side of the trading account, which is the revenue side. Is closing stock revenue? No! Closing stock is not revenue. It is recorded on the credit side of the trading account only due to the application of the matching concept.
The cost of opening stock and purchases is charged as an expense to the trading account by recording them on the debit side of the trading account. Revenue generated by selling them is matched against them by recording sales on the credit side of trading account.
Expenses of a certain number of units should be matched against the revenue generated by the sale of the same number of units. If, however, there are some unsold units, their cost must not be charged to the trading account.
Therefore, their cost is deducted by recording them on the credit side. The following example will demonstrate the concept effectively.
Suppose that 100 units of goods were purchased at $50 per unit. The total purchase of $5,000 (100 x 50) will be shown on the debit side of the trading account.
Now suppose that all of the units have been sold at $80 per unit. These sales of $8,000 (100 x 80) will be recorded on the credit side of the trading account.
The gross profit is $3,000 (8,000 – 5,000). Here, we are matching the expense (purchase price) of 100 units with the revenue (sales price) of 100 units, which is quite logical.
In Example 3, suppose that only 80 units are sold at $80 per unit. The resulting sales of $6,400 (80 x 80) will be recorded on the credit side of the trading account.
If the closing stock of 20 units is not recorded on the credit side of the trading account, the gross profit will be $1,400 (6,400 – 5,000).
This gross profit is not accurate because, in this case, we are matching the expense (purchase price) of 100 units with the revenue (sales price) of 80 units.
According to the matching concept, the only expenses that are matched against the revenue are those that are incurred to produce such revenue.
In this regard, the expense (purchase price) of 80 units only should be matched against the revenue (sales price) of 80 units. Hence, the expense of 20 unsold units will be recorded on the credit side of the trading account to reduce the expense of 20 unsold units.
Here, we are matching the expense (purchase price) of 80 units against the revenue (sales price) of 80 units, which is logical. The true gross profit on sale of 80 units will be $2,400 (6,400 + 1,000 – 5,000).
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.